BREXIT RECESSION?

SUMMARY

A slowdown is under way and there is some probability that a BREXIT recession is coming.

The UK economic engine spluttered in early 2018, faced with some cold east winds and persistent policy doubts. There should be some rebound from adverse weather effects, but other uncertainties will last a while longer.

It is always a matter of concern when the inflation rate is higher than the growth rate. It tends to mean a sluggish economy and constrained living standards. With inflation rates easing and some signs of earnings growth, we must hope that this imbalance (see chart below) does not last long.

Sadly, the consensus is that a modest outlook will persist. For example, the OBR’s March forecast has real GDP growth at or below 1.5% per annum over the next five years with investment at 2.5% p.a. or less.  Given normal forecasting errors, it doesn’t take much of a ‘shock’ to push 1.5% growth down to zero.

We are experiencing the ‘wrong’ kind of growth. Rather than productivity-led, long-term sustainable, ‘green’ growth fuelled by investment, innovation, skills, entrepreneurship and competitiveness, we have growth held back by 1) subdued consumption – high debts, low real wages, an ageing population, 2) an unsupportive policy mix – too loose money and high fiscal debt, and 3) an uncertain global outlook – Brexit unknowns and President Trump’s mercantilism.

Against this background, many businesses seem focused on the here and now and micro rather than macro prospects.  Some firms/sectors strive hard to fill near-term order books and manage skills shortages, whilst others fear unfavourable EU supply chain shifts from March 2019 (Brexit) onwards.  Unfortunately, messages from used car sales, garden centres, and other leisure and retail services suggest final (consumer) demand has softened in recent months. Household spending is not growing robustly, especially in real terms. This has affected retailers in the high street, tourism and other consumer services, and elements of discretionary construction. In contrast, high-end manufacturers and most business services remain relatively buoyant. Current trading and investment seem to be driven by capital replacement and capacity maintenance rather than building future growth potential.

The UK Economy

LATEST EVIDENCE

  Annual (2017) Quarterly Monthly
Real GDP (%ch, yoy) +1.9 +1.2 (Q1) n.a.
CPI inflation (%ch, yoy) +2.7 +2.7 (Q1) +2.5 (Mar)
LFS unemployment (%) 4.4 4.4 (Q4) 4.2 (Dec-Feb)
Current Account (£bn) -82.9 -18.4(Q4) n.a.
Base rate (%) 0.29 0.5 (Q1) 0.5 (Apr)

Source: ONS

The UK economy (see table above) slowed through 2017 and has started 2018 sluggishly – just 0.1% qoq growth in the first three months. There have been signals of weak consumption and investment growth, dampened by modest expectations about future earnings and profits. Surveys of consumer confidence have been softening.

The international environment has not helped, with a number of trade and diplomatic factors adding uncertainty – threatening a ‘cold war’ and a ‘trade war’. The US President is risking a return of mercantilism: the belief that it is the share of the cake, rather than the size of the cake, that matters. Such economic policies were abandoned a century and a half ago – their revival now would be a retrograde step.

Meanwhile, all this political controversy has been reflected in a stock market correction, commodity price swings and volatile exchange rates, adding market uncertainty to political and policy uncertainty. No wonder more people are back to a ‘wait and see’ mode of thinking, planning and commitment.

The essence of the problem, with or without Brexit, is that the UK economy has experienced the ‘wrong’ kind of growth for a number of years, almost to the point of establishing a ‘new normal’. The monetary and fiscal policy mix adopted to deal with the risks of debt and depression at the start of this decade seem intractable. At the same time, household and business prospects are constrained, and constraining, in an economy not built on productivity but on debt and cheap labour.

Crucially, the UK growth/inflation mix (discussed earlier and below) and the debt/deficits mix are unfavourable. The current account deficit remains large (3.6% of GDP in Q4 2017) and the public debt ratio huge at 86% (fiscal 2017/18). An ageing population, falling household living standards, weak investment incentives also contribute to the ‘wrong’ kind of growth, with low creative destruction and poor competitive aspiration.

Although some improvement was experienced in the second half of 2017, the “productivity puzzle” persists, with output per hour still about 20% below trend and the ‘gap’ with our competitors not shrinking. In essence, we have too many low value jobs in a weak investment cycle and not enough robust supply chains based on ‘collaborative yet competitive’ business relationships.

OBR FORECASTS

The Spring release by the OBR in March barely changed its forecasts from November. The key messages were: the cyclical economy is weak: growth is not expected to exceed 1.5% per annum between now and 2022; the structural economy is weak: growth potential remains modest by historical standards because productivity is still poor and the fiscal economy is weak: the public finances remain precarious – the deficit is shrinking but the debt burden is not.

Essentially, the OBR is predicting more of the same over the forecast period: growth not fuelled enough by investment, productivity and real earnings.   The economy is operating near to potential and there is little spare capacity. In the near term, Brexit uncertainty may dampen domestic and foreign direct investment, whilst reducing net positive immigration, compared with what otherwise might have occurred.

The wider consensus is the same. The latest HM Treasury compilation has growth of 1.5% in 2018 and 1.4% in 2019. The UK economy is precariously balanced with low growth and higher inflation (2.3% and 2.1% respectively). Historically, if it persists, the latter being at a higher rate than the former has proved uncomfortable for growth and jobs.

ECONOMIC STABILITY

Interest rates remain very low and are only expected to increase slowly over the next few years. At some point, base rates probably need to get back to about 3.0-3.5% (roughly equivalent to underlying nominal GDP growth), if pre-Great Recession ‘normality’ is to be restored.

As long as this is done in small, slow steps, such an adjustment need not hurt overall economic growth. There may be some pain for over-extended household and corporate debtors who may not have planned properly for higher rates, but a gradual process of change to more ‘normal’ interest levels will improve resource allocation for and by most economic actors in time – a likely condition for getting the economy working sustainably towards the ‘right’ kind of growth.

The question, however, is whether pre-2010 ‘normality’ is a viable target or only of academic/historical interest. The west’s policy response to the debt crisis, including zero interest rates and ballooning central bank balance sheets (quantitative easing – QE), avoided a Great Depression. But, the resulting, persistent debt pile (worldwide over $230trn and over 300% of GDP), was merely shifted from private to public balance sheets. This implies a risk of a renewed funding default if creditors lose confidence in the ability of debtors to repay, particularly as the costs of borrowing (bond yields) edge higher.

As the central banks start to unwind the ‘2010-model’, it is not clear that a return to the ‘old normal’ is possible. The risk is that another crisis hits when the authorities have less room for manoeuvre: a drop of interest rates of the scale seen at the start of the decade to support activity levels is not now feasible. With growth at no more than 1.5% per annum, a fairly small negative ‘shock’ could push the UK towards recession and the Bank of England has less room to do anything about it. In this respect, current evidence of a softening of final demand is worrying. Moreover, it makes a shift towards more sustainable investment and productivity-led growth even more urgent.